The Correlation Quandary

Kirnu, a steel roller coaster in Linnanmäki.

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It's not exactly a secret that volatility has stepped back to center stage during the last couple of months. To put it in perspective, from January, 1st 2011 to August 1st the DJIA had 200+ point intraday moves 18 times. Since August 1st we have seen intraday moves of 200 points or greater a staggering 42 times, with 9 of those over 400 points. The underlying question is “What is driving these extreme stock movements”?

This is sort of a “which came first, the chicken or the egg?” type of question. One key culprit of the volatility is the historically high level of correlation within the equity markets. In a nutshell, correlation refers to the statistical measure of how two stocks (or other financial instruments) move in relation to each other. Currently, we seem to have the whole market moving in unison on any given day, with relatively little concern being paid to the individual fundamentals of stocks. As Scott Billeadeau of Fifth Third Asset Management said, "…….. I'm just buying stocks or I'm selling stocks, versus buying IBM and selling Hewlett-Packard."

Ok, then why the correlation? It has been created largely in part by the overwhelming global and political influences driving the investment community to move in lockstep with one another. As JP Morgan puts it, “a significant driver of correlation between stocks is the prevailing macroeconomic environment. During periods of high macro uncertainty, stocks prices are driven by macro factors such as economic growth, unemployment, interest rate changes, inflation expectations, etc. Therefore, during changes in macroeconomic regimes, stock prices tend to move in unison leading to a high level of correlation”.  Now combine this with the increased usage of Index based ETF’s and algorithmic trading strategies, and you have a tremendous force behind the market, capable of rapid triple digit moves.

So to recap, the volatility has been exaggerated by the high correlations, which in turn was created by the volatility.  How do we break this cycle and return to “normal” trading patterns? It appears that until Europe gets their debt crisis under control, and the US is able to get the economy more stable footing, this roller coaster could remain the norm.

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